Watch yield spreads as Monti calls it quits

Will European Central Bank’s bond-buying plan keep the peace?

WilliamL. Watts

Italy's prime minister, Mario Monti, at the World Policy Conference in Cannes, France, over the weekend. Monti plans to step down by year’s end.

FRANKFURT (MarketWatch) — European Central Bank President Mario Draghi’s firewall is holding up, with markets outside Italy reflecting only modest anxiety Monday over Italian Prime Minister Mario Monti’s decision over the weekend to step down early amid domestic political turmoil.

Italian government bonds sold off in a knee-jerk reaction, sending yields higher and widening the all-important yield premium demanded by investors to hold Italian and Spanish government bonds over safe-haven German bunds. Italian stocks also sank.

“This is the first real test of the resilience of Italy’s bond market since Draghi’s game-changing pledge in July to do whatever it takes to shore up the euro zone,” Nicholas Spiro, managing director of London-based Spiro Sovereign Strategy, said late Sunday.

“Investors are nervous about any change in policy, particularly on the fiscal front,” said Nick Stamenkovic, macro strategist at RIA Capital in Edinburgh. But by historical standards, the carnage in the bond market on Monday remained relatively modest, he said.

The yield on Italy’s 10-year government bond
IT:10YR_ITA
rose 0.28 percentage point to 4.81%, according to electronic trading platform Tradeweb. The spread between Italian and 10-year German bund
DE:10YR_GER
yields widened by 0.27 percentage point to stand at 3.51 percentage points.

European equities initially fell and Wall Street started the day on a weak note, before turning higher. The FTSEMIB Italy index
I945, -0.89%
remained in negative territory, losing 2.2%, the most of any regional country index on Monday.

The euro
EURUSD, +0.0768%
dipped in early action but held its ground, changing hands near $1.2928 in recent action, little changed from levels seen late Friday.

Monti this weekend told Italy’s president he was prepared to resign as soon as parliament passes a pending budget law, setting the stage for early elections that would likely come by February. The move comes after former Prime Minister Silvio Berlusconi withdrew last week his PDL party’s support for Monti’s technocratic government.

The icing on the cake: The scandal-plagued Berlusconi will attempt to win the premiership once again. Though Berlusconi faces long odds, expectations he will call for the return of the lira and disappointment over Monti’s early demise was certain to spark at least near-term market indigestion.

Yield spreads

Yield spreads remain the best guide to tensions in the euro zone, strategists said. A massive widening of the spreads between peripheral and core yields would likely undercut overall risk appetite, spilling over to drag down equities.

The spread is the premium investors demand to hold a country’s debt over German paper that is viewed as relatively risk-free. The outright yields on Spanish and Italian paper have fallen sharply since late July, when Draghi pledged to do “whatever it takes” within the ECB’s mandate to preserve the euro. Spreads versus German have also narrowed sharply.

In November 2011, the yield spread between Italy’s 10-year bond
IT:10YR_ITA
and the German bund
DE:10YR_GER
reflected panic, hitting a euro-era record wide 7.24 percentage points, according to electronic trading platform Tradeweb.

The spread soon narrowed last winter after the ECB launched a liquidity-providing round of long-term refinancing operations but then widened back to more than 6 percentage points by July.

Since Draghi’s pledge and the subsequent introduction of the ECB’s aggressive bond-buying program—dubbed outright monetary transactions, or OMTs—spreads had continued to narrow sharply.

Moreover, the rally by Italian government bonds had accelerated since August, leaving the market vulnerable to a bout of profit-taking before year-end, said Luca Cazzulani, deputy head of fixed-income research at UniCredit Ban in Milan.

Monti has won praise for moving to implement an overhaul, albeit somewhat watered down, of Italy’s rigid labor laws while taking steps to ensure a primary budget surplus (i.e., the government’s fiscal position excluding debt payments).

Critics — and Draghi himself — rightly point out that the ECB’s OMT program still leaves it up to Europe’s politicians to solve the imbalances at the heart of the euro-zone debt crisis. In other words, the OMT promise is yet another in a long line of measures that have kicked the proverbial can down the road in an effort to buy time for politicians to take action.

Reuters/file 2008

Silvio Berlusconi.

Berlusconi may have kicked the can back. But in order to meaningfully unsettle markets, the billionaire septuagenarian will need to see a significant improvement in the polls.

Meanwhile, markets may pay more heed to Pier Luigi Bersani, the poll-leading center-left politician who has pledged to uphold Monti’s policies.

Nevertheless, the current situation underscores the crucial role Italy plays in Europe’s debt crisis. The euro zone’s third-largest economy and the home of the world’s third-largest government bond market, Italy remains potentially too big to be saved.

Regardless of the initial reaction, Monti’s exit would still be a loss for what Steen Jakobsen, chief economist at Saxo Bank in Copenhagen, dubbed Europe's “extend-and-pretend crowd” of policy makers.

While Berlusconi’s PDL polls with only around 15% support, he appears set to campaign on a seething anti-European Union slant, which is certain to upset Brussels and the ECB, while potentially fanning anti-euro resentment across the recession-wracked euro-zone periphery, he said.

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